Research insights from active investors

Why Brazil’s crisis creates new concerns

Michael J. Atkin, Portfolio Manager, May 26, 2017

On the evening of May 17, Brazilian asset markets weakened sharply following the revelations of evidence linking President Michel Temer to hush money being paid to the jailed former Speaker of the Brazilian lower House, Eduardo da Cunha. The reaction in asset markets was swift and violent. The stock market fell 8.8% the next day; the real traded from its May 17 close of 3.14 to the dollar to 3.38 by the close on May 18; local interest rates rose by about 150 bps across most of the curve; and the yields on dollar-denominated sovereign debt rose by about 50 bps across most of the curve. Local rates rose further on May 19, but other Brazilian assets recouped some of their losses.

Why this crisis is different

Accusations and revelations of corruption are hardly new to Brazil. The problem posed by this scandal, however, is more complicated. Temer himself was President Dilma Rousseff’s vice president and took office after the impeachment of Dilma, following a clear, constitutionally determined procedure. The details of how his replacement would be chosen if he were to be impeached are much less clear (see “Background note” below). Moreover, even though the transition from Dilma to Temer followed a clear process, it took a long time, and the economy weakened significantly throughout the drawn-out process of impeachment and replacement.

Reform has been making progress

Most importantly for Brazil, Temer had been able to build a coalition in Congress to make significant progress on key economic reforms, and the prospect of these reforms had led a great deal of foreign capital to flow into Brazil. This capital inflow strengthened the real, allowed domestic interest rates to fall, and permitted the central bank to begin an easing cycle designed to support the economic recovery. The revelations of May 17 were seen as a threat to the Temer administration, and therefore a threat to the short- and medium-term economic outlook.

Brazil’s Congress plays a role

President Temer refused to resign in the immediate aftermath of the revelations. The release of the audiotape on which the accusations against him were based showed that there was no clear “smoking gun,” particularly as the tape was of poor quality and much of it was ambiguous. While it is certainly possible that there will be further revelations and accusations in the near future, at the time of writing, there is no clear sign of the president’s political allies abandoning him. In part, this is likely because many members of Congress are concerned that they will themselves get caught up in the ongoing investigation of the Lava Jato (“Car Wash”) affair. In part, it is because there is no consensus on who might be a plausible replacement for Temer as president and what kind of congressional support a replacement could command.

Two possible scenarios for Brazil

Uncertainty remains high, but we see two different possible scenarios for the current scandal’s impact on Brazil’s economy and markets.

Scenario 1: Temer remains in office. He is weakened politically, and his economic reform agenda stalls, or, even under the best possible scenario, is delayed. The economic recovery loses momentum, and creditworthiness slowly erodes.

Scenario 2: Temer is forced from office, either by impeachment, resignation, or via a legal case about the 2015 election that is working its way through the courts. Such a process would take some time, during which the economic recovery would suffer. Subsequent developments would depend on who replaces him:

A new political figure, with an uncertain power base in Congress. This could be very bad for Brazilian assets, as the new leader would likely lack popular legitimacy.

A “technocratic” figure is installed as a placeholder until the next national election. The name of former President Cardoso has been mentioned. Under this scenario, it is possible that the economic reform agenda could continue. Notably, the government is rapidly approaching the limits of its legal authority to spend, so some spending measures would have to be passed in short order.

The asset price implications of these different scenarios are not entirely clear. Against a global backdrop that remains favorable for emerging markets, much will depend on domestic (i.e., Brazilian) investors’ perceptions of political risk.

Background note: How could Temer be replaced?

Michel Temer took office after the impeachment of the former president, in the manner laid out in the Constitution. If he were to leave office for any reason, the Constitution sets out a procedure for installing the next president. The presidency would pass following the line of succession: first, to the Speaker of the Lower House; second, to the Speaker of the Senate; third, to the Chief Justice of the Supreme Court. The new president would hold office for 30 days, and would be replaced by a person chosen by the Congress, acting as an electoral college.

However, Brazil’s Constitution provides no guidance about who is eligible to be a candidate in such a process, nor about the guidelines that would govern the election. The Supreme Court would probably have to become involved, or the Congress itself would have to pass clarifying legislation. It is not clear how long this would take.

This lack of clarity matters when thinking about what comes next. When the impeachment of Dilma Rousseff was being considered, the clear line of succession to Michel Temer clarified the choice facing those who supported or opposed impeachment. In the case of the possible impeachment of Temer, there is no such clarity.

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Michael J. Atkin, Portfolio Manager Mr. Atkin is a Portfolio Manager in the Global Fixed Income group. He is responsible for managing core global fixed income, emerging-market debt, fixed income global alpha, and global government strategies. In addition, he leads the macroeconomic discussions as part of the Portfolio Construction group and manages a team of analysts who evaluate government securities in G7 countries and emerging markets. Mr. Atkin joined Putnam in 1997 and has been in the investment industry since 1988.

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